Not since the Russian “Grain Robbery” or the Ferruzzi soybean scandal has a trading entity generated as much controversy as “the funds” now do. The influx of billions of dollars since the 2000-2001 stock market peak has fueled a bull market in commodities, as demonstrated by the CRB Index, which has nearly doubled.
The rally began in energy and spread to metals, with agriculture so far left in the dust. “That just means funds will view the ag markets as a better opportunity to buy low and ride the wave up when they see a buy signal,” says Dan Basse of AgResource Company in Chicago.
Savvy farm marketers already view funds as fairy godmothers for better sales opportunities, not wicked wizards for the volatility they cause. Understanding how the funds operate and their effect on markets opens the door to higher prices for your production. The funds influence the prices you receive in at least seven ways, outlined by Basse at the 2006 Top Producer Seminar in late January:
• More volatility. Markets will see many more 10% price moves (11 in 2005 in corn). Prices will rise higher than fundamentals would suggest because certain funds trade from the long side. Lower lows also may occur at times, however.
Producers may have to market crops several times during the year, adopt selective hedging and be more flexible in their outlook. It also means you and your banker should plan more cash availability for marketing outlays.
• Costly options. Greater volatility spells higher premiums on options. Option volatility will not fall as much or as fast as in prior years. This all means risk management via long puts and calls will cost more, but writing options will bring in more. Advisers may recommend buying a put and selling a call to offset part of the expense, for example. Some even suggest selling calls to enhance your price. In either case, if prices rise and the call is exercised, you enter a short hedge in the futures market.
• Shifts in seasonal trends. The funds’ biggest impact is in the end of the fourth quarter and early first quarter. Harvest lows and post- harvest rallies could be pushed back by 20 to 30 days as funds strive to buy at the low. Buying Thanksgiving and selling Christmas/New Years appears to be a new seasonal trade as the market prepares for the onslaught of index fund buying in the new calendar year. That buying also could short- circuit February lows, ending them earlier than normal.
• Futures spreads. Carry markets (later contracts priced above nearby) will prevail as index funds roll their massive net long position forward as each contract approaches expiration.
This means better returns to storage. It also exposes producers to the temptation to hold off pricing, believing that prices will be higher later. This may not come to pass, as the later month may fall toward the nearby rather than vice versa.
• Wider basis swings. Grain and soybean basis will be far more volatile as elevators adjust to the new futures volatility. On fund rallies, the difference between futures and cash price will widen. Look to lock in basis at futures price lows. This also means hedges will be more attractive on rallies than will cash contracts.
• Better loan deficiency payments. Both LDPs and marketing opportunities will increase as funds drive futures outside normal ranges.
• Wild livestock markets. Livestock, where funds control a larger share of open interest, could see the biggest price impacts.
The bottom line. The upshot, says Basse, “is that we need to watch the CRB Index as an indicator of general interest in commodities; monitor fund positions; use technical analysis more to alert us to buy/sell signals; choose marketing tools that maintain flexibility; and consider basis levels when deciding whether to price via cash contracts or futures or options.”
For AgResource’s daily updates on fund positions, click on the link at www.ToProducer.com.
Three types of commodity funds
The funds actually include several different types—traditional, index and hedge, points out AgResource’s Dan Basse, who serves as a consultant to fund managers.
• Traditional commodity funds became active in the Chicago Board of Trade and Chicago Mercantile Exchange markets in the mid-1980s. Estimated invested capital stands at about $172 billion, up 31% from a year ago.
These funds have the strongest correlation between daily activity and price—in some markets, such as corn or soybeans, as much as 90% on a daily basis. The correlation is not as strong for wheat (84%), cattle (86%) or hogs (82%).
These are the funds whose position is reported in the “large trader category” by the Commodity Futures Trading Commission (CFTC) every Friday. AgResource tracks their positions daily. “In corn, if funds are short 60,000 to 80,000 contracts, you know it is better to buy than sell,” he notes. “If they are long 130,000 contracts or more, look to harvest the funds by selling.” The parameters for soybeans are 40,000 or more short and 60,000 long. Similarly, he advises that if funds account for about 15% of corn open interest, be cautious. “If they approach 30%, it suggests a major market high,” he says. “In soybeans, over 25% is where caution is warranted.”
These funds most commonly use an optimized 50-day moving average; some also incorporate seasonal trends. They tend to enter and exit markets at about the same time.
• Index funds invest in a basket of commodities. They are always long—once they invest, it becomes an issue of rolling their position forward as contracts approach their delivery period. Their investment is estimated at $102 billion.
Index funds are relative newcomers to the business, mainly since 2001. Some large pension funds now devote 1% to 3% of their capital to commodities; Harvard’s endowment fund is reported to have invested 12% of its assets.
Three major players are the Goldman Sachs Commodity Index (estimated at $56 to $60 billion; tends to invest at year end and in February); Dow-Jones-AIG Index Fund ($11 to $14 billion; invests the second week of February); and PIMCO Commodity Fund ($8 to $10 billion; end of quarter). Note however, that Goldman has only 10% of its assets in agriculture and 5% in livestock, while energy accounts for 76% and metals, 10%.
“Longer term, we fear that index funds could die the death of 1,000 cuts,” says Basse. “The costs may eat into returns enough to eventually sour investors.” In a carry market, each roll typically means a loss of 1% to 3% of the fund’s value, he says. “We estimate that funds will lose 14% to 16% a year just on rolls, and that’s before management fees. “
Those losses are partially offset (only 4% to 4.5%) by their investing a portion of their capital in financial instruments. “The net result is that over time, index funds require large rallies in four to seven markets [Goldman’s index trades 24] to maintain profitability and public interest,” says Basse. “If/when investors exit these funds, it will create downward pressure across the broad commodity spectrum.”
Note that because index fund positions currently are considered hedges, they have no contract limits and their position is impossible to follow, he adds. The CFTC is considering setting up a separate reporting category.
• Hedge funds are willing to chase any investment theme. They prefer the long side of the market, but will go short when opportunity exists, according to Basse. They tend to rely on seasonal price trends, preferring to be long heading into a new growing season, for example.
Most hedge funds use a combination of fundamental and technical analysis, trading a fundamental trend but using charts to signal when they should enter and exit.
“They will pounce on a major Corn Belt drought market and rally prices to higher-than-anticipated levels,” Basse cautions. “The pits at the Chicago Board of Trade may not be able to handle all the new-found volume, causing limit-up days and difficulty in getting orders filled.”
Hedge funds often are willing to absorb losses of 20¢ in corn, 30¢ in wheat and 40¢ to 50¢ in soybeans to realize a long-term trend.more cash flows into them.
